Credit spreads are discussed casually, but they are rarely getting factored into fixed investment portfolios. Everyone seems to be solely focused on yield, although investors were reminded of the danger of duration risk after witnessing the poor performance of most fixed benchmarks. The Barclays Aggregate Bond Index, for example, delivered a negative total return for the last 24 months, despite the index currently having an average yield of ~3.3%. Meanwhile credit spreads are near historical lows and, like duration risk, investors may not wake up to the underlying risk until they get hurt, which will happen when credit spreads widen.
The graph shows the extra yield earned from buying high yield versus investment grade bonds. This spread is earned for taking on potentially significantly more risk, but it is now near multi-year lows. It is becoming more a matter of when, not if, credit spreads will widen, so credit selection is more important now than it has been in many years.
If I told you that two companies are in the same industry and one company makes $50 million in profit per year while the other makes $1 billion, would you charge them the same rate for a loan? What if one company is the #2 producer in the world and the other is the #15 producer? You’d clearly charge more to the smaller, less relevant company, but how much more? The difference in interest rates on the two loans is the difference in credit spreads, and right now the market is only demanding a little extra yield for potentially substantially more risk.
Looking at the two extreme segments of the bond market, AA bonds are extremely safe, but not quite the absolute highest quality, in the eyes of the rating agencies, so they are just below AAA. Currently, the spread over Treasuries on 2-year AA corporate bonds is only 0.21% versus a year ago at 0.33% or roughly 5 years ago at 0.49%. The credit spread has collapsed by ~60%. On the other end of the spectrum, the credit spread for CCC debt, very risky high yield debt, is reaching dangerously low levels as many fixed income investors chase yield and conveniently (basically) ignore credit quality. This strategy can work in the short term when economic growth is strong and expected to remain so through the debt’s maturity. However, the economy is already almost a decade into an expansion so now is not the prudent time to go out too far on the risk spectrum, hoping that the economy will have zero hiccups for the next 5 years.
Somewhere in between the safest and riskiest bonds lie the BBB bonds, high enough to be considered investment grade, but not nearly safe enough to be considered almost government quality. The BBB market has grown dramatically in the past decade and now composes roughly 50% of the total corporate investment grade market. Recent articles have discussed BBB companies’ average leverage increasing, but leverage is typically defined as total debt to total earnings before interest, taxes, and non-cash depreciation/amortization (EBITDA). These articles generally fail to mention the significant positive impact of corporate tax changes on cash flow and leverage. Since most investment grade companies have relatively healthy levels of earnings, this is a significant oversight. Also, many companies following the financial crisis completed strategic acquisitions which improved their businesses via synergies or diversification and in some cases both. Some companies definitely completed acquisitions primarily with debt because the acquisitions increased earnings per share and cash flow. Even this type of financial engineering, however, can be done prudently by employing only a moderate amount of incremental debt with a clear path to deleveraging in the near term. Because of the underlying improvements in leverage (tax cut) and improvements in business models (acquisitions), numerous BBB bonds remain very attractive even in today’s low-spread credit market.
Investors must remember that not all credits with the same rating are necessarily equally risky. For example, a lodging company with multiple hotels across the country is likely to have superior credit quality as compared to a single service business with no hard assets or patents. An economic downturn or a technological change could significantly impair both business, and from a credit perspective the probability of the hotels being worth more than a moderate amount of debt is significantly higher given the hard assets and asset diversity. While each credit situation is different, as a credit investor I care much more about the asset base, the business risk, and the cash flow characteristics than the rating, especially since rating changes occur all too often after the fact.
With credit spreads extremely tight and many companies utilizing debt to complete acquisitions, careful selection of both investment grade and high yield bonds is of the utmost importance. We once again get back to highlighting that credit selection matters, whether it requires recognizing credit spread risk or duration risk. Not all bonds are created equal even if the market can sometimes appear to make such a simplifying assumption when higher yield is the soup du jour. Chasing yield blindly and ignoring credit spreads is living dangerously on the edge, and eventually you are bound to get hurt.